Economic Capital
Overview
Economic capital is the name given to a firm wide
value at risk measure. It is referred to as capital
because it is envisioned as the size of the capital buffer needed to keep a company from bankruptcy to a certain
degree of probability.
Types of Risk
The primary types of risk for which banks allocate capital are
Banks may also choose to allocate capital for other risks, such as
operational risk,
however, these secondary capital allocations are generally much smaller, and also harder to measure.
Basel Formulas
The Basel Committee on Banking Supervision is a committee of banking supervisors who collectively agree on a set of
international standards
for
for bank capital, liquidity and funding. These standards are non binding, however, they are generally followed by member countries.
As part of the published standards, Basel produces a set of formulas
for managing bank risk. The formulas for calculating bank capital from
a set of default models is available in the davinci library.
Capital Allocation
Capital Allocation:
One of the common frameworks that banks use to measure performance is capital allocation. That is, once ecoonomic capital
has been calculated for the bank as a whole, the banks managers allocate the capital to the various bank divisions or products.
Once a division has been allocated capital, the bank can then measure a risk performace measure for the division, such as
RAROC by dividing the divisions profits by the capital allocated to it.
